1. SE-IE: Law of Demand 1

2. Effect of a Price Change
Clothing
(units per
month)
Assume:
I = $20
PC = $2
PF = $2, $1, $.50 10 4 5 6 U2 U3 A B D U1 12 20
Three separate
indifference curves
are tangent to
each budget line.
Food (units
per month)
Chapter 4 4

3. Effect of a Price Change
Clothing
(units per
month)
The price-consumption
curve traces out the
utility maximizing
market basket for the
various prices for food. 6 A
Price-Consumption Curve U1 5 D B 4 U3 U2
Food (units
per month) 4 12 20
Chapter 4 4

4. Effect of a Price Change
of Food
Demand Curve
Individual Demand relates
the quantity of a good that
a consumer will buy to the
price of that good. H E G
$2.00 4 12 20
$1.00
$.50
Food (units
per month)
Chapter 4 4

5. The Individual Demand Curve
Two Important Properties of Demand Curves
1) The level of utility that can be attained changes as we move along the curve.
Chapter 4 4

6. The Individual Demand Curve
Two Important Properties of Demand Curves
2) At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing.
Chapter 4 4

7. Effect of a Price Change
of Food
Demand Curve
E: Pf/Pc = 2/2 = 1 = MRS
G: Pf/Pc = 1/2 = .5 = MRS
H:Pf/Pc = .5/2 = .25 = MRS
When the price falls: Pf/Pc & MRS also fall H E G
$2.00 4 12 20
$1.00
$.50
Food (units
per month)
Chapter 4 4

8. Individual Demand Income Changes
Using the figures developed in the previous chapter, the impact of a change in the income can be illustrated using indifference curves.
Chapter 4 4

9. Effects of Income Changes
Clothing
(units per
month) D 7 16 U3
Assume: Pf = $1
Pc = $2
I = $10, $20, $30 5 10 B U2
Income-Consumption
Curve
An increase in income,
with the prices fixed,
causes consumers to alter
their choice of
market basket. 3 4 A U1
Food (units
per month)
Chapter 4

10. Effects of Income Changes
Price of
food
An increase in income,
from $10 to $20 to $30,
with the prices fixed,
shifts the consumer’s
demand curve to the right. 16 D3 H 10 D2 G 4 D1 E
$1.00
Food (units
per month)
Chapter 4

11. Individual Demand Income Changes
The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.
Chapter 4 4

12. Individual Demand Income Changes
An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.
Simultaneously, the increase in income shifts the demand curve to the right.
Chapter 4 4

13. Normal Good vs. Inferior Good
Individual Demand
Normal Good vs. Inferior Good
Income Changes
When the income-consumption curve has a positive slope:
The quantity demanded increases with income.
The income elasticity of demand is positive.
The good is a normal good.
Chapter 4 4

14. Normal Good vs. Inferior Good
Individual Demand
Normal Good vs. Inferior Good
Income Changes
When the income-consumption curve has a negative slope:
The quantity demanded decreases with income.
The income elasticity of demand is negative.
The good is an inferior good.
Chapter 4 4

15. An Inferior Good 15 30 Steak (units per month) 10 5 20 HamburgerC
Steak
(units per
month)
Income-Consumption
Curve
…but hamburger
becomes an inferior
good when the income
consumption curve
bends backward
between B and C. 10 5 20 A U1 B U2
Both hamburger
and steak behave
as a normal good,
between A and B...
Hamburger
(units per month)
Chapter 4

16. Individual Demand Engel Curves
Engel curves relate the quantity of good consumed to income.
If the good is a normal good, the Engel curve is upward sloping.
If the good is an inferior good, the Engel curve is downward sloping.
Chapter 4 4

17. Engel Curves 30 20 10 4 8 12 16 Income ($ per month) Food (units
Engel curves slope
upward for
normal goods. 30 20 10
Food (units
per month) 4 8 12 16
Chapter 4

18. Engel Curves 30 Inferior Normal 20 10 4 8 12 16 Income ($ per month)
Engel curves slope
backward bending
for inferior goods.
Inferior
Normal 20 10
Food (units
per month) 4 8 12 16
Chapter 4

19. Substitutes and Complements
Individual Demand
Substitutes and Complements
1) Two goods are considered substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other.
e.g. movie tickets and video rentals
Chapter 4 4

20. Substitutes and Complements
Individual Demand
Substitutes and Complements
2) Two goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other.
e.g. gasoline and motor oil
Chapter 4 4

21. Substitutes and Complements
Individual Demand
Substitutes and Complements
3) Two goods are independent when a change in the price of one good has no effect on the quantity demanded of the other
Chapter 4 4

22. Individual Demand Substitutes and Complements They could be both!
If the price consumption curve is downward-sloping, the two goods are considered substitutes.
If the price consumption curve is upward-sloping, the two goods are considered complements.
They could be both!
Chapter 4 4

23. Income and Substitution Effects
A fall in the price of a good has two effects: Substitution & Income
Substitution Effect
Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.
Chapter 4

24. Income and Substitution Effects
A fall in the price of a good has two effects: Substitution & Income
Income Effect
Consumers experience an increase in real purchasing power when the price of one good falls.
Chapter 4

25. Income and Substitution Effects
The substitution effect is the change in an item’s consumption associated with a change in the price of the item, with the level of utility held constant.
When the price of an item declines, the substitution effect always leads to an increase in the quantity of the item demanded.
Chapter 4

26. Income and Substitution Effects
Income Effect
The income effect is the change in an item’s consumption brought about by the increase in purchasing power, with the price of the item held constant.
When a person’s income increases, the quantity demanded for the product may increase or decrease.
Chapter 4

27. Income and Substitution Effects
Income Effect
Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.
Chapter 4

28. Income and Substitution Effects: Normal Good
Clothing
(units per
month) C2 F2 T U2 B
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. R F1 S C1 A U1 E
Total Effect
Substitution
Effect D
The substitution effect,F1E,
(from point A to D), changes the
relative prices but keeps real income
(satisfaction) constant.
The income effect, EF2,
( from D to B) keeps relative
prices constant but
increases purchasing power.
Income Effect
Food (units
per month) O
Chapter 4

29. Income and Substitution Effects: Inferior Good
Clothing
(units per
month)
Total Effect
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect. B
Income Effect U2 R A D
Substitution
Effect U1
Food (units
per month) O F1 E S F2 T
Chapter 4

30. Income and Substitution Effects
A Special Case--The Giffen Good
The income effect may theoretically be large enough to cause the demand curve for a good to slope upward.
This rarely occurs and is of little practical interest.
Chapter 4